Bilateral netting, by law

Parliament passed the Bilateral Netting of Qualified Financial Contracts Bill, 2020 during the recently concluded Monsoon Session, and with this important legislative reform the long wait for a bilateral netting law is over.

Globally, close-out netting has not only protected the derivative participants following a default by the counter-party, it has also enabled reduction in credit exposure resulting in substantial savings on account of capital savings and reduction in fund requirements for margins.

For instance, in case of close-out netting, say, the defaulting and non-defaulting parties are engaged in two interest rate swap transactions: for the non-defaulting party, Transaction 1 involves a payment of ₹10 lakh, while Transaction 2 involves a receivable of ₹8 lakh. If close-out netting is enforceable, the non-defaulting party is obligated to pay the net difference of ₹2 lakh to the defaulting party. But if close-out netting were not enforceable, the non-defaulting party would be obligated immediately to pay ₹10 lakh to the defaulting party but then wait, possibly months or years, for whatever fraction of the ₹8 lakh gross amount it recovers in bankruptcy.

Reducing overall risk

The result of close-out netting is to reduce credit exposure from gross to net exposure. The policymakers have consistently supported the enforceability of close-out netting, as it reduces the overall risk and strengthens the systemic stability of the financial sector. That is why most of the major countries for the over-the-counter (OTC) derivatives market (about 50 countries) have already established a legal framework for bilateral netting of financial agreements resulting in saving of billions of dollars.

The present legal framework in India does not allow netting of bilateral financial contracts (OTC derivatives), forcing banks to provide capital on gross basis for such derivatives, thereby trapping large amounts of capital unproductively with banks. On the other hand, there is a legal framework in place for multilateral transactions, which results in substantial savings.

Netting is also important to implement the margin system for non-centrally cleared OTC derivatives (NCCDs). Due to the evolving global consensus on imposition of margins for NCCDs, it has become necessary for India to implement the exchange of margin system to strengthen stability and resilience of the financial sector. Imposition of such margin on gross basis would make the OTC derivative market very costly and may seriously disrupt this market, as such derivatives account for a significant part of the total derivatives market.

Recognising that the law on bilateral netting would be a significant enabler for efficient margining, the RBI announced in February that the margin system would be introduced for such non-centrally cleared OTC derivatives.

The Bilateral Netting of Qualified Financial Contracts Bill, 2020 would provide an unambiguous legal framework for bilateral netting and would result in huge savings for the participants, besides reducing the overall risk. This important legal reform would result in the following benefits:

(i) The reduction in counter-party credit risk exposure through netting will strengthen resilience of the financial sector.

(ii) It would encourage price efficiency of derivative products on account of optimisation of capital use and enable banks to increase credit limits for counterparties and clients.

(iii) It would facilitate development of the corporate bond market by energising the credit-default swap market.

(iv) It would enable simplification of business exits by improving the recovery mechanism for financial contracts when counter-party to such a contract defaults.

The savings of banks on account of both capital savings post-enactment of the law and fund savings post-imposition of margin for OTC derivatives could be productively used for extending financing support to the productive sectors of the economy. The savings of banks on account of both capital savings and fund savings were estimated to be around ₹42,000 crore for the year 2017 and around ₹58,000 crore for the year 2020. It is important to mention that when banks are struggling to preserve capital in view of the increasing requirements of provisioning for stressed assets, such savings would be quite valuable.

So, a firm legal basis for netting and exchange of margin system would not only enable substantial fund savings for banks and strengthen the resilience of the financial sector by reducing the overall risk and support the economy, it would also bring India on par with other major markets for OTC derivatives in terms of prudential regulation.

The writers are Secretary, Department of Economic Affairs, and Adviser, Department of Economic Affairs, Government of India